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INTRODUCTION
Exchange Rate Arrangements
Broadly speaking, the exchange rate of any currency can be settled in two ways: either administered by the central bank, or by demand and supply in the exchange market. Various combinations of the two extremes are not only possible but also are more the rule. The IM classifies the exchange arrangements of member countries under three broad heads: !egged, to a single currency "the #.$. dollar and the euro are most common%, or a currency composite like the $&'. lexibility limited against a single currency or group of currencies "the &anish (rone against the euro for example% More flexible arrangements like )managed floating*, and )independent floating*. The di+iding line between )independently floating* "the dollar, the euro and the yen for example% and )managed floating* often gets blurred in practice. To the extent the group of se+en ", - of IM %, or indi+idual central banks, inter+ene in the exchange market in pursuance of international economic co.operation or domestic macro.economic ob/ecti+es, the exchange rate if the independently floating currencies is also managed. 0s per the IM 1s 2xchange 0rrangements and 2xchange 'estrictions 0nnual 'eport 344-, the number of pegged currencies was 54, of currencies with limited flexibility was 35, and the remaining 44 currencies had more flexible arrangements. 6ith the introduction of the euro with effect from 3.3.3444, the number of currencies with limited flexibility has come down from the numbers 7uoted here.
ey to the !ar"et
6hen trading in the foreign currency exchange, you undoubtedly need a orex trading strategy. :a+ing a orex trading strategy is crucial to the success of your in+estments in this +olatile and ceaseless market. 6ith the right knowledge you can take your money and trade it right.
Ad'antages o# The Forex !ar"et orex is open @H hours a day. orex is the most li7uid market in the world. large amounts of capital.
9ommission.free trading on more than 5K currencies. Io restrictions on shorting which allows during any market condition you to en/oy profit opportunities
Aimited floor trading hours dictated by the The orex market is open @H hours a day, time 8one of the trading location, G.G days a week. Because of the significantly restricting the number of decentrali8ed clearing of trades and hours a market is open and when it can be o+erlap of ma/or markets in 0sia, accessed. Aondon and the #nited $tates, the market remains open and li7uid throughout the day and o+ernight. Threat of li7uidity drying up after market hours or because many market participants decide to stay on the sidelines or mo+e to more popular markets. Most li7uid market in the world eclipsing all others in must comparison. continue, is a Most since re7uired transactions currency commerce.
exchange
!attern daytraders sub/ect to restrictions Io restrictions. Very low account balances. re7uiring account balances in excess of FGK,KKK.
RBI Study In the early 34=K1s, the 'BI undertook a study of the real effecti+e exchange rate of the rupeeM it was published in the series of ?ccasional !apers, Bune34=H, ")The Iominal and 'eal 2ffecti+e 2xchange 'ate of the Indian 'upee 34-3.=D* by &r Vi/ay Boshi%. The principal conclusions of the study were that the real effecti+e rate "'2'% of the rupee depreciated by 33.GN between 34-3 and 34-G and by a further 3-N between 34-G and 34-4. rom 34-4 to 34=D, howe+er, it showed a sharp 3GN appreciation. It seems that, as a result of the study, the 'BI started to depreciate the rupee in nominal terms beginning late 34=D, so as to correct the earlier appreciation, and to depreciate the rupee modestly in )real*, i.e. inflation ad/usted terms. This policy continued up to Bune3443. In the first week of Buly 3443, a two.step de+aluation of the rupee was engineered "and the cash compensatory support for exports discontinued%, and the inter+ention currency changed to #.$. dollars. The next ma/or change was the introduction of a liberali8ed exchange rate management system "A2'M$% in March 344@. This introduced a dual exchange rate system. ?ne rate was the administered "or official% one at which specified type or proportion of currency exchange had to be transacted. or example, out the receipt of foreign exchange exports, 5KN had to be sold in the market at the market rate and the balance surrendered to the 'eser+e Bank at official rate. The foreign currency purchased by the 'BI through this mechanism was sold to importers of oil "and a few other products% at the official rate. The market rate was determined by the demand and supply in the market and, as can be expected, the rupee was at a discount in the market, as compared to the official rate. In
Foreign Exchange !ar"ets Re'ie* ++,anuary - ,une. /0001 Re'ie* done during Decem2er /0001 rom 0ugust 3444 to March @KKK, 'e traded in a narrow band of around 's. HD.GK per #$F. 0t end.march, 'e at HD.53 to a #$F.
3K
'BI undertook net sales of #$F 34H= mn during May.Bune @KKK to meet temporary &&. $$ mismatches. In order to reduce the uncertainty the 'BI undertook the following steps: Interest rate surcharge of GKN of the lending rate on import finance of all non.essential imports. orex re7uirements for import of crude oil to be met by I?9.
'BI would continue to sell #$F. Banks told not to deal for speculati+e purposes. !enalty of @GN p.a. on o+erdue export bills.
33
3@
3D
In India Reser'e 5an" o# India has gi'en &icense to the commercia& 2an"s to dea& in #oreign exchange under section 6 Foreign Exchange Regu&ation Act. 789:. *hich are ca&&ed Authori;ed dea&ers +A Ds1< A&& the 2an"s that ha'e 2een Authori;ed to dea& in #oreign exchange co&&ecti'e&y constitute *hat is "no*n as =Inter 2an"> mar"et in India< They are re?uired to #o&&o* the Ru&es)guide&ines Framed 2y Foreign Exchange Dea&er>s Association o# India +FEDAI1
Centra& 5an"s In most of the countries central bank ha+e been charged with the responsibility of maintaining the external +alue of the domestic currency. If the country is following a fixed exchange rate system, the central bank has to take necessary steps to maintain the parity, i.e., the rate so fixed. 2+en under floating exchange rate system, the central bank has to ensure orderliness in the mo+ement of exchange rates. ,enerally this is achie+ed by the inter+ention of the bank. $ometimes this becomes a concerted effort of central banks of more than one country. 0part from this central banks deal in the foreign exchange market for the following purposes. Exchange rate management: Though sometimes this is achie+ed through inter+ention, yet where a central bank is re7uired to maintain external rate of domestic currency at a le+el or in a band so fixed, they deal in the market to achie+e the desired ob/ecti+e Reser'e management: 9entral bank of the country is mainly concerned with the in+estment of the countries foreign exchange reser+e in a stable proportions in range of currencies and in a range of assets in each currency. These proportions
3H
3G
Inter'ention 2y Centra& 5an" It is truly said that foreign exchange is as good as any other commodity. If a country is following floating rate system and there are no controls on capital transfers, then the exchange rate will be influenced by the economic law of demand and supply. If supply of foreign exchange is more than demand during a particular period then the foreign exchange will become cheaper. ?n the contrary, if the the supply is less than the demand during the particular period then the foreign exchange will become costlier. The exporters of goods and ser+ices mainly supply foreign exchange to the market. If there are no control o+er foreign in+estors are also suppliers of foreign exchange. &uring a particular period if demand for foreign exchange increases than the supply, it will raise the price of foreign exchange, in terms of domestic currency, to an unrealistic le+el. This will no doubt make the imports costlier and thus protect the domestic industry but this also gi+es boost to the exports. :owe+er, in the short run it can disturb the e7uilibrium and orderliness of the foreign exchange markets. The centra& 2an" *i&& then ste$ #or*ard to su$$&y #oreign exchange to meet the demand #or the same< This will smoothen the market. The central bank achie+es this by selling the foreign exchange and buying or absorbing
35
Exchange 5ro"ers orex brokers play a +ery important role in the foreign exchange markets. :owe+er the extent to which ser+ices of forex brokers are utili8ed depends on the tradition and practice pre+ailing at a particular forex market center. In India dealing is done in interbank market through forex brokers. In India as per 2&0I guidelines the 0&1s are free to deal directly amoung themsel+es without going through brokers. The forex brokers are not allowed to deal on their own account all o+er the world and also in India.
3-
@o* Exchange 5ro"ers %or"( Banks seeking to trade display their bid and offer rates on their respecti+e pages of 'euters screen, but these prices are indicati+e only. ?n in7uiry from brokers they 7uote firm prices on telephone. In this way, the brokers can locate the most competiti+e buying and selling prices, and these prices are immediately broadcast to a large number of banks by means of hotlines>loudspeakers in the banks dealing room>contacts many dealing banks through calling assistants employed by the broking firm. If any bank wants to respond to these prices thus made a+ailable, the counterparty bank does this by clinching the deal. Brokers do not disclose counterparty bank1s name until the buying and selling banks ha+e concluded the deal. ?nce the deal is struck the broker exchange the names of the bank who has bought and who has sold. The brokers charge commission for the ser+ices rendered. In India broker1s commission is fixed by 2&0I. O'erseas Forex !ar"ets Today, the daily global turno+er is estimated to be more than #$ F 3.G trillion a day. The international trade howe+er constitutes hardly G to - N of this turno+er. The rest of trading in world forex markets is constituted of financial transaction and speculation. Aondon has been the biggest market and continues to be so e+en today. :owe+er, many other cities ha+e de+eloped as ma/or trading centers. 0s we know that the forex market is @H ; hour market, the day begins with Tokyo and thereafter $ingapore opens, thereafter India, followed by Bahrain, rankfurt, !aris, Aondon, Iew Cork, $ydney and back to Tokyo. &ealers ha+e access to the dealing not only during their business hours but remain acti+e from their residences also.
3=
S$ecu&ators $peculators play a +ery acti+e role in the foreign exchange markets. In fact ma/or chunk of the foreign exchange dealings in forex markets in on account of speculators and speculati+e acti+ities. The speculators are the ma/or speculator in the forex markets. 3. Banks dealing are the ma/or speculators in the forex markets with a +iew to make profit on account of fa+ourable mo+ement in exchange rate, take position i.e., if they feel the rate of particular currency is likely to go up in short term. They buy that currency and sell it as soon as they are able to make a 7uick profit. @. 9orporations particularly Multinational 9orporations and
Transnational 9orporations ha+ing business operations beyond their national frontiers and on account of their cash flows. Being large and in multi.currencies get into foreign exchange exposures. 6ith a +iew to take ad+antage of foreign rate mo+ement in their fa+our they either delay co+ering exposures or do not co+er until cash flow materiali8e. $ometimes they take position so as to take ad+antage of the exchange rate mo+ement in their fa+our and for undertaking this acti+ity, they ha+e state of the art dealing rooms. In India, some of the big corporate are as the exchange control ha+e been loosened, booking and canceling forward contracts, and a times the same borders on speculati+e acti+ity. D. ,o+ernments narrow or in+est in foreign securities and delay co+erage of the exposure on account of such deals.
34
@K
For exam$&e. $rice o# US Do&&ar +USD1 or Deutsche !ar" +DE!1 or ,a$anese Yen +Yen1 can 2e ex$ressed in terms o# Indian Ru$ees +INR1< Thus i# *e say. USD 7 C Rs< D6. it means that the exchange rate o# USD and Ru$ee is 7:D6< simi&ar&y. i# *e say. B54 7 C Rs< 68 it means that the exchange ratio o# B54 and Ru$ee is 7:68<
&ifferent countries ha+e adopted different exchange rate system at different time. The following are some of the exchange rate system followed by +arious countries.
@3
@@
@D
@H
@G
#nder purchasing power parity "!!!% the sole criterion to determine exchange rate of currency of two countries was their purchasing power. If there were temporary de+iations from the purchasing power parity theory, the market forces would operate to remo+e them. If there were no trade controls, then as per this theory, the balance of payments e7uilibrium would always be maintained.
For exam$&e i# country A had a higher rate o# in#&ation as com$ared to country 5 then goods $roduced in country A *ou&d 2ecome cost&ier as com$ared to goods $roduced in country in country 5< This *ou&d induce im$orts in to country A and a&so the goods $roduced in country A 2eing cost&ier. *ou&d &ose in internationa& com$etition to goods $roduced in country 5< This decrease in ex$orts o# country A as com$ared to ex$orts #rom country 5 *ou&d &ead to demand #or the currency o# country 5 and excess su$$&y o# country A< This in turn. causes currency o# country A to de$reciate in com$arison o# currency o# country 5 that is ha'ing re&ati'e&y more ex$orts<
@5
@-
@=
@4
Currency 5as"et
Instead of linking their currencies with a single currency, some countries had linked their currencies with a basket of currencies. Iormally, the basket consists of the currencies of the countries who are trading partners and weight age to the respecti+e currencies is gi+en in accordance with trade figures. The ad+antage of such a linkage was that the exchange rates of the currency, linked to the basket or currencies, through and through other currencies do not depend on the fortunes of single currency and thus are more stable and balanced. ?n $eptember @G, 34-G rupee was de.linked from pound sterling and was linked to basket of currencies. The main ad+antage of linking a rupee with the basket of currencies was that it was no longer be dependent on the +agaries of a single currency and India was free to exercise its discretion to alter the currency components in basket without allowing market to speculate on rupee exchange rate. 'eser+e Bank announced the buying and selling rate for pound sterling which would keep the exchange rate stable as the 0.&1s had access to 'eser+e Bank for buying or selling unlimited amounts. Thus if the interbank market was selling pound sterling at more than the 'BI rate, the bank could buy from 'BI, at 'eser+e Bank1s rate which was at lower rate. This will push down the interbank exchange rate. $imilarly, if the interbank market were buying pound sterling at a lower rate than the 'BI rate, then bank would sell to 'BI at 'eser+e Bank1s buying rate which was higher rate. This will push the exchange rate upward. Thus the interbank market always remained within the rates announced by 'BI.
DK
The 'eser+e Bank, with a +iew to support exports, was buying #$&, ,B!, &2M and C2I, spot and forward. To maintain reasonable supply of F#$ spot and for sometime forward also. In +iew of this buying and selling rates of 'BI, which were acting as floor and ceiling rates, the interbank market remained within these rates. :owe+er, the main criticism of this system was that it did not allow market forces of demand and supply to determine the exchange rates. 6ith the liberali8ation wa+e sweeping through the real and financial sectors, it was only natural to allow the forces of demand and supply to determine exchange rates. The li7uidity crunch in 344K and 3443 on forex front only hastened the process. ?n March 3, 344@ the 'BI announced a new system of exchange rates known as Aiberalised 2xchange 'ate Management $ystem "A2'M$%.
D3
Forex & Risk Management Ei2era&ised Exchange Rate !anagement System +EER!S1
The main ob/ecti+e of introducing Aiberalised 2xchange 'ate Management $ystem "A2'M$% was to make balance of payments sustainable on ongoing basis by allowing market forces to play a greater role in determining exchange rate of rupee. 6hile introducing the new exchange rate system ,o+ernment of India and 'BI were led by the following considerations: 9ontaining current account deficit at sustainable le+el. Introducing an element of e7uilibrium in imports and exports on an automatic basis. Imparting necessary degree of flexibility in the exchange rate system. 2nsuring that the cost of imported goods did not rise too high or abruptly. (eeping capital outflows under control and effecti+ely monitor the same. 0s per A2'M$, the rupee became o+erall con+ertible for all appro+ed transactions. The exporters of goods and ser+ices and those who recei+ed remittances from abroad were allowed to sell bulk of their foreign exchange receipts i.e., 5KN of it at market determined rates. :owe+er, they were re7uired to surrender HKN of such receipts to the 'BI through 0uthorised &ealers at ?fficial rate "?'% announced by the 'BI. $imilarly, those who needed foreign exchange to import and tra+el abroad were to buy foreign exchange and trade control regulations in force. In cases of certain essential items of imports, the 'eser+e Bank made a+ailable foreign exchange at official rate. $ubse7uently, in March 344D, the A2'M$ was replaced by the unified exchange rate system and hence the system of market determined exchange rate was adopted. :owe+er, the 'BI did not relin7uish its right to inter+ene in the market to enable orderly control.
D@
In addition, the foreign exchange market of India was characteri8ed by the existence of both official and black market rates with median premium. :owe+er, such black market premium steadily declined during the following decades until 344D.
DD
!ethod O# Fuotation
DH
DG
3.H4H@ ; 3.H==5
3.H4D@ ; 3.H4H@
3.3@=5 ; 3.3@3G
3.3@-5 ; 3.3@=K
33G.-G ; 33D.==
33G.@= ; 33D.DD
D5
D-
'eady or cash ; +alue today Tomorrow ")tomm*% ; +alue tomorrow, or next working day $pot ; +alue two business days after the trading date "one business day for 9an F : #$ F transaction and F : Cen contracts in the east%. Thus, for a spot transaction done Monday, currencies will change hands the following 6ednesday assuming this is a working day in both the centres. $imilarly, for a spot transaction done Thursday, currencies will change hands the following Monday, there being no forex transaction on $aturdays and $undays. 6hile the definition of )spot* maturity seems straight forward, in practice some difficulties crop up because of different holidays at different centres, particularly in case of cross currency "i.e. neither currency is home currency of the centre% trades. 9onsider a dollar: euro trade in Aondon on a riday. In the normal course settlement will be on the following Tuesday if this is a business day in Aondon, Iew Cork rankfurt "The euro will change hands in rankfurt and the dollars in Iew Cork%. If Tuesday happens to be a holiday in nay of the three centres, then settlement will be postponed to 6ednesday. But what if Monday, not Tuesday, is a holiday in AondonS In that case a specific settlement date date is agreed by the counterparties, generally the )spot* day for the bank initiating trade. For*ards - any 'a&ue date 2eyond s$ot< The rules for determining +alue dates of standard maturities of forward transaction are as follows ; 3. In general, the value date of a one !onth for"ard contract "ill #e the date in the next !onth corresponding to the $spot% value date& Aet us consider a transaction done on Monday, the 3= th Banuary 3444. The +alue date for a spot transaction will be 6ednesday the @K th Banuary and the
D=
D4
HK
H3
Borrow #$& 3.3@=K for one month in the spot market on the 3@ th ebruary at H. 3G>35. Buy euros spot at #$& 3.3@=K per 2#'. &eposit euros for one month at D.3>35 per cent. "It should be noted that all the abo+e transactions ha+ing done in the spot market on the 3@th ebruary, currencies will change hands on the 35th ebruary%. 9alculate the forward rate by e7uating the maturing amount of principal and interest in the two currencies ; remember, interest has to be calculated for @= days and, as is the practice for both dollars and euros, on a D5K.day year basis. "Iote that for borrowings and buying euros the rates used are the market1s )offered* ratesM similarly the )bid* rate for euro deposits has to be used to calculate the interest on the euro deposit% 0ssuming that #$& 3.3@=K was borrowed, the principal and interest to be repaid on maturity would be F 3.3D@D on 35th March as follows: #$& 3.3@=K Q #$& U"3.3@=K T H.4D-G T @=% > "3KK T D5K%V P #$& 3.3D@D ?n the other hand, the deposit of euro 3.KK at D.3>35 per cent would fetch 2#' 3.KK@H as follows: . 2#' 3.KK Q 2#' U"3.KK T D.K5@G T @=% > "3KK T D5K%V 27uating the two, the offered one.month forward rate for the euro, therefore, comes to #$& "3.3D@D> 3.KK@H% or F 3.3@45.
H@
0 contract can now be entered into to sell 2#' 3.KK@H, deli+ery 35 th March, at #$& 3.3@45 per euro on a fully hedged basis. The receipt of this comes to F 3.3@43 per 2#'. The one.month forward 7uotation therefore is F 3.3@43>45. It will be noticed that the margin between the bid and offered rates is higher than for the spot rate. In practice, this widening of margins can used to determine whether a forward margin is a premium or discount. The spot rate is #$& 3.3@-5>=K per 2#' and the one.month forward margin is 7uoted as K.3G>35 cents. 6e are not sure whether this is a premium or a discount on the euro. If it were a discount on the euro, forward euros would be cheaper. The forward rate would therefore be #$& 3.3@53>5H per euro, deducting the margin from the spot rate. That case the spread is actually lower "D )basis* points%. $ince the spread on forwards has to be wider, the margin cannot be a discount. 9onsidering it as a premium we get the forward 7uote as #$& 3.3@43>45 per euro, and this is the correct position. ?n other point should be noted as regards the calculation of forward rates using the money market route. 9onsider how the offered rate for euros was calculated ; the money market position was )short* in dollars "represented by the borrowing% and )long* in euros "represented by the deposit%. Iow, an offer can be made for euros against dollars ; the maturing euro deposit can be paid out in meeting the offered euros while the incoming dollars will be used to repay the dollars borrowed, ending to with a s7uare position. In other words, in the money market you are )long* in the currency you ha+e to pay out and )short* in the currency the counterparty is to pay you. 0gain, the amount to be borrowed>deposited has to e such that, together with interest, it e7uals the contract amount. In the abo+e example, if you are writing a contract to offer a million euros at #$& 3.3@45, the euro deposit plus interest thereon should total 2#' 3 mn. $o the euros to be bought with the dollar borrowing need to be 2#' 44-,5@H, which with interest at
HD
For euros against ru$ee For euros against ru$ee H@.5@T3.3@45 's H=.3HD5 H@.G=T3.3@43 's H=.K--3 The customer rate would be arri+ed after loading the appropriate margin and rounding off ; say 's. H-.4= > H=.@H. 2arlier, we had calculated the one.month dollar: euro rate as #$& 3.3@43>45. This was of course for deli+ery on a fixed day ; namely 35 th March 3444 and the dollar was at a discount +is.W.+is the euro. If the two.month forward rate was, say, #$& 3.3DK5>3@ per 2#', the bid and offered second month option rates for the euro would be #$& 3.3@43>3.3D3@. "i.e. the bid, or buying , rate for the euro includes one month1s premium on the euro while the offered, or selling, rate for the euro includes the full two months1 premium%. The spread between the bid and the offered rates is now much wider ; a cost the counterparty pays for the flexibility of choosing the +alue date for the transaction on any day in the second month. For*ard Rate C S$ot Rate I 4remium ) G Discount In foreign exchange market forward transaction are necessary for following reasons: ?ne can hedge or co+er an existing future financial, commercial or trade related exchange risk.
HH
These types of deals, in combination of spot deals, are used for money market operations through O$60! transactions1. Taking a +iew of the market, these can be used for speculation
4remium
6hen a currency is costlier in future "forward% as compared to spot, the currency is said to be at premium +is.W.+is another currency. In O&irect 'ate1 premium is always added from both buying and selling rate and in OIndirect 'ate1 premium is always deducted to both buying and selling rate.
Discount
6hen a currency is cheaper in future "forward% as compared to spot, the currency is said to be at discount +is.W.+is another currency. In O&irect 'ate1 discount is always deducted from both buying and selling rate and in OIndirect 'ate1 discount is always added to both buying and selling rate. It can be mentioned here that to a+oid confusion, it is the base currency for which the premium>discount is always mentioned. Factors A##ecting 4remium)Discount orward differentials are relati+ely but are not constant and therefore, +ary from time to time. The following factors affect forward differentials:
HG
7< Su$$&y and demand #or the currency #or a sett&ement date< If for a currency for a particular settlement date, there are more buyers than sellers the forward differential will go up. $imilarly, if a currency for a particular settlement date, there are more sellers then buyers the forward differential will go down. This is all the more true when there is restriction of capital flows. /< !ar"et ex$ectation Market expectations about the de+elopment in interest differentials and exchange rates of the currencies on account of +arious factors. :< Interest rate di##erentia&s Interest rate differentials between the currencies exchanged. In fact, this is the only factor, which affects the forward differentials pro+ided capital flows are free from restrictions. orward differentials are a function of interest differentials and if they are at +ariance with each other they will gi+e rise to Oarbitrage1 opportunities. This is based on simple logic of trade off between interest earned on one currency and opportunity foregone to earn interest in another currency. I&&ustration: S$ot US3 7 C DE! 7<J000 Interest #$F X D N per annum, &2M X 5 N per annum.
H5
Thus, a person can make #$F D in 3 year by borrowing #$F 3KK for 3 year X D N p.a., con+ert it into &2M and lace the same as deposit for 3 year X 5N. :owe+er, we ha+e presumed that exchange rate remains the same. The forward exchange rate of #$F>&2M will be ad/usted by market forces to eliminate arbitrage opportunities. Therefore, #$F>&2M rate would be the same. #$F 3KD P &2M 3G4 Therefore, #$F 3 P &2M 3.GHD5 Thus K.KHD5 represents the forward differential between spot and one year. It may be noted that #$F is at a premium against &2M.
!erchant Rates
H-
H=
Interest rates. Monetary policy. !olitical factor. 2xchange control. 9entral bank inter+ention. $peculation. Technical factors. 2xpectation of the foreign exchange market.
H4
GK
!ar"et Forecasts
After deter!ining its Exposures, the co!pany has to for! an idea of "here the !ar/et is headed& The company will focus on forecasts for the next 5 months, as forecasts for periods beyond 5 months can be unreliable.
G3
@edging
This is the !ost visi#le and gla!orised part of the Exposure 0anage!ent function& Ho"ever, the Trader is li/e the 1river in a car rally, "ho needs to follo" the general directions of the 2avigator& :edging strategies will be designed to meet the 2xposure Management ob/ecti+es, as represented by the Benchmarks The 2xposure Management 9ell will be accorded full operational freedom to carry out the hedging function on a day.to.day basis
:edges will be undertaken only after appropriate $top.Aoss and Take.!rofit le+els ha+e been predetermined The company will use all hedging techni7ues a+ailable to it, as per need and re7uirement. In this regard, it will pass a Board 'esolution authorising the use of the following: 3. 'upee. oreign 9urrency orward 9ontracts @. 9ross 9urrency orward 9ontracts D. H. orward.to. orward 9ontracts '0s
G. 9urrency $waps
G@
Sto$ Eoss
2xposure Management should not be undertaken without ha+ing a $top.Aoss policy in place. 0 $top.Aoss policy is based on the following two fundamental principles: 3. To err is human @. 0 stitch in time sa+es nine It is appropriate to recount here some words from a speech &r 0lan ,reenspan, 9hairman of the #$ ederal 'eser+e, deli+ered in &ecember 344-, on the 0sian financial crisis. :e says,
GD
)There is a significant bias in political systems of all +arieties to substitute hope "read, wishful thinking% for possibly difficult pre.empti+e policy mo+es. There is often denial and delay in instituting proper ad/ustments 'eality e+entually replaces hope and the cost of the delay is a more abrupt and disrupti+e ad/ustment than would ha+e been re7uired if action had been more pre.empti+e. 6hether an 2xposure is hedged or not, it is assumed that the decision to hedge> not to hedge is backed by a View or orecast, whether implicit or explicit. 0s such, $top Aoss is nothing but a commitment to re+erse a decision when the +iew is pro+en to be wrong.
Suggestions: $top Aosses should be acti+ated when 9ritical le+els in the rate being monitored are reached, which clearly tell that the +iew held has been pro+en wrong. The factors> assumptions behind a +iew either change or are pro+en wrong. The 2xposure Manager should be accorded flexibility to set appropriate $top.Aosses for each trade. The 2xposure Manager should, howe+er, make sure he has set a stop.loss for positions he enters into, on an a priori basis.
6hile Benchmarks will be based upon the Big Trend and will incorporate a certain amount of room for error, the 2xposure Manager should be careful to not +iolate the Benchmark on the wrong side.
GH
ortnightly Monthly
Issue
On the 2asis o#
4oints to 2e re'ie*ed
GG
G5
G-
De'a&uation G Re'a&uation &e+aluation is a sudden decrease in the market +alue of one currency with respect to a second currency. 0 re+aluation is a sudden increase in the +alue of one currency with respect to a second currency. %ea"en G Strengthens If a currency weakens it losses +alue against another currency and we get less of the other currency per unit of the weaken currency ie. if the Z weakens against the &M there would be a currency mo+ement from @ &M>Z3 to 3.= &M>Z3. In this case the &M has strengthened against the Z as it takes a smaller amount of &M to buy Z3. Eong 4osition - Short 4osition 0 short position is where we ha+e a greater outflow than inflow of a gi+en currency. In Y short positions arise when the amount of a gi+en currency sold is greater than the amount purchased. 0 long position is where we ha+e greater inflows than outflows of a gi+en currency. In Y long positions arise when the amount of a gi+en currency purchased is greater than the amount sold.
G=
currency other than your base currency. But not necessarily /ust then. 0ny company selling products o+erseas or importing goods from abroad has a foreign exchange exposure. Indeed, e+en a company manufacturing and selling only in one country can ha+e a significant degree of economic exposure to changing foreign exchange rates. It must be noted that a sterling based company doing business in the domestic marketplace will suffer foreign exchange exposure if any of its competitors are based in a foreign country e+en though prices are in sterling. or example, a #( +ideo manufacturer making e7uipment sourced entirely from the #( parts and sold entirely to the #( market has a Bapanese Cen exposures if the company has Bapanese competitors, because a weak Bapanese Cen "unlikely recently% gi+es his Bapanese competitors in the #( market an ad+antage. or a group such as I9I, with manufacturing plants in HK countries, selling organisations in another 5K and sales in at least 3GK of the 35K or so so+ereign states, the management of foreign exchange risk has long been a task of the treasury function. The im$ortant ?uestions raised 3. 6hat types of exposure are to be managedS There are three main types of risk, which we will consider in a later section. 6e must analysis this exposure and the company should ha+e a clear policy and direction from the Board. 9ompanies may differ in the way they conceptualise foreign exchange risk "especially economic exposure%. The industry type will sometimes shape the way the treasurer +iews the exposure. 2xposures can gi+e rise to cash flow effects and others are accounting "affecting financial statements%. $ince these positions are sub/ect to rapid change. 9hanges in foreign currencies need to be anticipated. @. 6hat sources of financial information should your company ha+e in identifying their exposureS 6hat currency>interest rate expertise input is there when marketing>purchasing decision are madeS :ow effecti+e are the company and
G4
5K
@edging in'o&'es ta"ing an e?ua& and o$$osite $osition to the asset or &ia2i&ity *hich is ex$osed< 2xposed asset "or liability% loses +alue the hedge compensates by increasing in +alue. 2xposed asset "or liability% gains +alue, the hedge compensates by decreasing in +alue. :owe+er, it is often not as clear.cut as hedging can in+ol+e different policies: Static @edging . where the o+erriding concern to a+oid risk.
53
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or example, the following company estimates rench sales in 3445 to be @KK million. They base their hedging on a+erage of rates of the pre+ious four years.
Cear in which co+er was taken out for a percentage of 3445Es re+enue
344G GKm @KKm . $plit @GN into the pre+ious four years @GN
5D
O$$ortunistic @edging $ome companies will choose to hedge only in those situations in which they expect a currency to mo+e in a direction that will make hedging feasible ie only hedge future foreign currency payments when they expect appreciation in the foreign currency.
4ercentage Co'er 9o+ers percentage of known currency which allow uncertainty in forecasting currency +olumes. $uch uncertainty will be greater o+er longer periods. Se&ecti'e @edging #nder this policy the treasurer would co+er according to their forecast mo+ements in exchange rates. #sually all the companyEs exposure would not be left to the forecasting ability of the treasurer. :owe+er, in many, a proportion of the risk is left to be hedged at the discretion of the treasurer. ?b+iously the controls and guidelines gi+en to the treasurer on the maximum exposed position or maximum loss are +ery important under this policy. Currency trading In other words this is speculating. In some companies the treasurer will not only be in+ol+ed with hedging but will buy and sell currencies "going LlongL and LshortL% on
5H
undamental This is based on fundamental relationships between economic +ariables and exchange rates. ,i+en the current +alues of these +ariables and their historical impact on a currencyEs +alue the company can de+elop exchange rate pro/ections.
Market.Based This is forecasting based on current market indicators such as the current spot rate and the forward rate. Mixed Io single method has pro+ed entirely reliable or superior to others conse7uently treasurers may use a combination of forecasting techni7ues. @. ?+erall profitability of company The effect of currency mo+ements on the profitability of the company is ob+iously +ery important. 6ould any potential mo+ements ha+e a material effect
5G
based internationally. 9urrency risk management should be integrated with the operating side of the business. Therefore the treasurer should liaise with other departments on decisions on production, purchasing and management as these can all ha+e currency implications. D. 9ompetitors 6ith Y problems it is +ery important that the treasurer considers the nature of the companyEs competitors. They must ask 7uestions about where their competitor1s costs are sourced i.e., in what currencies, in which currencies is their income flows and do they undertake any hedging techni7ues. Iot all of this information will be a+ailable but the treasurer must attempt to consider these areas. This is best illustrated by a few examples. Telstart, a #( company, produces +ideos. Most of its re+enues are in the #(. 0bout half of its expenses re7uire outflows in Bapanese Cen "to pay for Bapanese materials%. Most of TelstartEs competition is from #( companies that ha+e no international business at all. If the Cen strengthens, TelstartEs will incur higher expenses when paying for the Bapanese materials. Because its competition is not affected in a similar manner, Telstart is at a competiti+e disad+antage when the mark strengthens. Bonhams, a #( company, produces furniture and has no international business. Its ma/or competitors import most of their furniture from Iorway, then sell it out of retail stores in the #(. If the, Iorwegian (rona strengthensM #( retail stores will likely ha+e to pay higher prices for the furniture from Iorway, and may pass
55
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5=
54
a. Z weakens [ F3>Z3 therefore income increases in ZEs +alue. b. Z $trengthening [ ZD>Z3 income decreases in ZEs +alue. The increase in +olatility of all currencies has made transaction exposure +ery dangerous, but it is comparati+ely easy to identify because it is specified and discrete being linked with indi+idual items of business. It may also be used to describe transactions, which are confidently expected to be booked soon, and transactions, which are forecast, as long as the forecast is a reasonably close one. There is a point in time . not clearly definable . when EtransactionE exposures merge into EeconomicE exposures. In general, transaction exposures are relati+ely easy to identify. or example, a #$ company exporting to a ,erman customer in &eutchsemarks has a transaction exposure to the #$ dollar>&eutchsemark exchange rate on the money they are due to recei+e for sales they
-K
the firm will be reduced Transaction exposure is by its nature of uncertain timing, and its co+er should not be considered in a static or item.by.item manner. The exposure in an on.going business is e+er e+ol+ing . changing day by day or e+en hour by hour . as business is won, orders are placed, payables paid, recei+ables recei+ed, or co+er taken. It is not often that the treasurer can say at any particular time that they ha+e co+ered all their foreign exchange exposure. Taking a broader, o+erall and forward looking +iew, more efficiently co+ers it. 9ompanies usually try to determine the net amount of inflows and outflows in each currency and determine the o+erall exposure to those currencies. or example, if a #( has two subsidiaries Y and C and subsidiary Y has a net cash inflow of &M 3,KKK,KKK and subsidiary C has a net cash outflow of &M 3,@GK,KKK, the consolidated net cash outflow is &M @GK,KKK for the chosen period. Therefore any currency mo+ement between the &M and the Z will be offset in the two subsidiaries apart from the outstanding consolidated flow. This information wills ofcourse usually be uncertain and companies ha+e sometimes to deal with possible ranges of cash inflows and outflows. 0fter the net cash inflow or outflow is established the company may try to predict possible ranges for each currency against the home currency to try and get some estimate of the le+el of exposure.
-3
!rotecti+e measures to guard against transaction exposure in+ol+e entering into foreign currency transactions whose cash flows exactly offset the cash flows of the transaction exposure. !rotecti+e measures include orward contracts
!rice ad/ustment clauses 9urrency options Borrowing and lending in the foreign currency In+oice in home currency 0nother related type of exposure is called pre.transactional exposure which occurs before a transaction has taken place. 0ny time a company produces a price list, or markets a bid or tender in a currency other that their home currency they are lea+ing themsel+es open to the effect of currency mo+ements making the prices in the list or tenders worth less in the home currency. This type of exposure is contingent on the transaction being carried out.
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2xposed 0ssets
2xposed Aiabilities
!ositi+e 2xposure oreign 9urrency &e+alues Translation loss Translation ,ain oreign 9urrency 'e+alues
2xposed 0ssets
2xposed Aiabilities
Iegati+e 2xposure oreign 9urrency &e+alues Translation ,ain Translation Aoss oreign 9urrency 'e+alues
The amount of translation exposure depends on the degree of foreign in+ol+ement of a multinationalEs o+erseas subsidiaries, the location of these foreign subsidiaries and the correlation between that currency and the home currency and the methods for accounting
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9ompanies ha+e at least three a+ailable methods for managing their translation exposure: 0d/usting fund flows 2ntering into forward contracts 2xposure netting Basic hedging strategy for reducing translation exposure is to increase hard currency "likely to appreciate% assets and decrease soft currency "likely to depreciate% assets, while simultaneously decreasing hard currency liabilities and increasing soft currency liabilities. Thus if de+aluation appears likely, the basic hedging strategy would be: 'educe le+el of cash Tighten credit terms to decrease accounts recei+able Increase local currency borrowing &elay accounts payable $ell the weak currency forward But acti+ities not automatically +aluable. If the market recognises the likelihood of currency appreciation, this recognition will be reflected in the costs of +arious hedging techni7ues. :edging exchange risk costs money and the costs need to be scrutinised like any other purchase of insurance.
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Economic Ex$osure The definition of EeconomicE and Ecompetiti+eE exposures +aries, and is less important than the underlying concepts. 0 EtransactionE exposure is one, which is readily identifiable in the currency in which it arises. ?nce the exposure is uncertain, or not genuinely in the currency in which the transaction is settled, it is usually called an EeconomicE exposure rather than a transaction exposure. The longer.term change in +alue relationship between two currencies gi+es rise to 29?I?MI9 exposure. It is the most subtle and insidious of all the types of exposure, and has the potential to ruin a company, but to do it in a +ery surreptitious manner. It arises when it is thought that future cash flows will be affected by changing exchange rates. 2conomic exposure can thus be thought of as the extent to which the present +alue of future cash flows is affected by exchange rate mo+ements. Transaction exposure is a subset of economic exposure. :owe+er economic exposure is taking place on a continuing basis, it has no time limit, nor a defined direction of mo+ement. It is simple to spot the influence of the expected change in exchange rates on forecasted sales columns. But the significance of changes in the +alue of competitorsE currencies, which appear unrelated to your operations, should not be underestimated. It is important to appreciate a competitorEs ability to take a greater market share or larger profit because changing exchange rates ha+e mo+ed in their fa+our. The term EeconomicE exposure may be used to describe any exposure, which is forecast to become a transaction exposure in due course . although, if the forecast can be made fairly accurately, this would often be regarded rather as a transaction exposure. The simplest example is when a forecast transaction does not occur. Iext yearEs sales budget for example "as opposed to next weekEs% can only be an estimate. If we forecast sales in pesetas of GKK million but only achie+ed DKK million, the difference of @KK million is an exposure which we expected but which ne+er occurred. It could therefore ha+e been
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--
Ris" A$$raisa&
This exercise is aimed at determining *here the com$anyMs ex$osures stand 'isGNG'is mar"et #orecasts< The following 'isks will be considered. 3. Ris" to the Ex$osure or Ha&ue at Ris" +HAR1
,i+en a particular +iew or forecast, V0' tries to determine by how much the company1s underlying cashflows are affected. The V0' is the answer
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This will take into consideration the risks attached with each particular market and the likelihood of a transaction not going through smoothly. or instance, The 'upee is gi+en to sudden swings in sentiment, whereas the &eutschemark is generally more predictable. The monetary and time costs of hedging with a nationalised bank are generally higher than with a pri+ate> foreign bank. ! Systems Ris" The risks that arise through gaps or weaknesses in the 2xposure Management system. or example:
Re$orting Ba$
6here there are delays> errors in reporting exposures to the 2xposure Management cell
Im$&ementation Ba$ 6here there is a gap between the decision to hedge and the implementation of such hedge decision.
5enchmar"ing
This exercise aims to state where the company would like its exposures to reach.
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=K
Ex$osure Ana&ysis
0n 2xposure can be defined as a 9ontracted, !ro/ected or 9ontingent 9ash low whose magnitude is not certain at the moment. The magnitude depends on the +alue of +ariables such as oreign 2xchange rates and Interest rates. The company will determine and analyse its oreign 2xchange exposures. 1eter!ination: The following cash flows> transactions will be considered for the purpose of exposure management. Haria2&e ) Cash F&o*s
Transaction Ty$e Both 9apital and 'e+enue in nature 0ll Interest !ayments> 'eceipts 0ll ?pen hedge transactions Both 9apital and 'e+enue in nature
9ontracted oreign 9urrency 9ash lows oreign Interest 'ates, whether loating or ixed 9ash lows from :edge Transactions !ro/ected> 9ontingent 9ash lows
=3
9ash lows abo+e F3KK,KKK>. in +alue will be brought to the notice of the 2xposure Manager, as soon as they are pro/ected. It is the responsibility of the 2xposure Manager to ensure that he recei+es the re7uisite information on exposures from +arious sections of the company in time.
Ana&ysis These exposures will be analysed and the following aspects will be studied:
oreign 9urrency 9ash lows> $chedules Variability of 9ashflows . how certain are the amounts and> or +alue datesS Inflow.?utflow Mismatches > ,aps Time Mismatches > ,aps 9urrency !ortfolio Mix loating > ixed Interest 'ate ratio
?b/ecti+es of risk management Minimi8e 9osts Maximi8e 'e+enue $tabili8e Margins in the uture
=@
=D
I&&ustration 2.g. Aet us consider an exporter in India exporting shirts to #$0. 6hile 7uoting the price per shirt he must ha+e arri+ed at the sale price by taking into consideration the cost of shirt say 's. HH and if he wants a profit of 's. 3 per shirt, he would like to sell the shirt for 's. HG. :e expects the payment to be recei+ed after one month and when he actually recei+ed the payment the exchange rate is #$F3 P 's. HD.=K. It can be easily seen that instead of making profit he has ended in loss of @K paise. To a+oid this type of uncertainty, the exporter would like to get lock in an exchange rate for future by entering into forward exchange forward contract. :e may get an exchange rate say one month
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"#
ixed date foreign exchange forward contract If under the foreign exchange forward contract, foreign exchange is to be deli+ered at fixed date, the contract is known as fixed date foreign exchange contract.
$# ?ption foreign exchange forward contract If under the foreign exchange forward contract foreign exchange is to be deli+ered in future, during a specified period, the contract is known as option foreign exchange forward contract. In this type of contract there is no option for taking>deli+ery of foreign exchange. $uch contracts pro+ide for option as far as date of deli+ery of foreign exchange is concerned. 6hile entering into a option
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@% O'ernight &imits &uring the daytime, position can be monitored continuously and correcti+e actions can be taken same is not possible at the night $o o+ernight limits are fix conser+ati+ely. But the same time it is big enough to accommodate pipeline transactions D% Cut &oss &imit Bank is ha+ing open position and if the rate mo+es against the bank then bank may loss. &ealer has the free hand to deal and he ne+er know that what will be the loss. If the rate goes against then bank max1 loss to pre+ent this limit is fixed by the management 0 maximum a dealer will loss due transaction is called the cut loss limit. 0s for example, if the permissible amount of 7uantum of absolute loss translates in to HK point mo+ement of the rate on a position of one million The cut loss has to be applied by the dealer x+ hen there is an ad+erse mo+ement of twenty points on a position of two million
=4
4K
/1 C&ean Ris" In an exchange contract the currencies are to be exchanged on the +alue dates The time 8one difference between +arious centre sometimes results in situations when one bank has already paid the amount of currency to be gi+en before recei+ing the amount the currency to be recei+ed the counter party fails, it may result in total loss. :1 So'ereign Ris" If the counter party bank is situated in different country then there is a possibility of ha+ing so+ereign risk. 0lso because of the political and economic factors in that country. If a country suspends the foreign currency payments the bark may stand to lose, although the counter party ha+e performed its part of the contract in local currency. The bank while fixing counter party limits for the o+erseas bank has to gi+e due weightage to the political stability, health of the economy, a+ailability of financial infrastructure, and expected state interference in financial transactions, particularly foreign exchange transactions. Ei?uidity ris" is the risk that bank will be unable to meet its funding re7uirements or execute a transaction at a reasonable price Market li7uidity risk is the risk of bank not being able to exit or offset positions 7uickly at a reasonable price. If a bank has undertaken a swap i.e. bought and sold same amount of foreign currency for different +alue dates, it does not ha+e exchange position but runs the risk of mismatches
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Total aggregate gap limit is the total of all T0,A1s in all currencies put together. This not only ensures controlling une+en cash flows on account of mismatches but puts under control trading in forward also. Trading in forwards is also called running a swap book1 #ncontrolled mismatches can create li7uidity problem for the bank, which may ultimately result in unintended losses.
Exchange dea&ings and ris" managements #or the 2an"s The bank, dealing in foreign exchange has not only to look for profits but also has also to ensure that the losses, which may be incurred in foreign exchange dealings, are minimi8ed. The foreign exchanged dealing is risk reward business and therefore the lure for profits is +ery strong. But it is not free from risk. oreign exchange dealings ha+e got certain special features, which make the transactions all the more risky. These are as follows: The foreign exchange dealings are transnational arid therefore prices of foreign currencies are sub/ect to the control>restrictions of the go+ernments of the foreign countries. These are also dependent upon their fiscal and monetary policies and the same are dictated buy the needs of their domestic economy oreign exchange dealings in+ol+e two currencies and therefore the exchange rate is influenced by domestic as well as international issues>factors The foreign exchange market is a @H hours market and different time 8ones for foreign exchange dealings at different centers offer threat of risk ad+erse mo+ement of rates on account of unexpected de+elopments. The foreign exchange dealings are to be undertaken at a +ery fast speed and pace there is no time for second thoughts. Therefore the fast decision making process itself opens the foreign exchange dealing to risk
4D
,lobally, foreign exchange dealing operations are undertaken with a +iew to maximi8e profits of bank :owe+er till the year 3443 in India foreign exchange dealings operations were sub/ect to stringent controls and the only ob/ecti+e of the dealing was to conduct co+er operations so as to facilitate international business The regulatory en+ironment in India hardly offered any scope for free foreign exchange dealings. :owe+er with introduction of liberali8ed exchange rate management system a new dimension has been added. 'upee has now becomes a free.floating currency under modified liberali8ed exchange rate management system "A2'M$% and the market forces of demand and supply decide rupee exchange rate. 'eser+e Bank of India slowly but steadily has been liberali8ing foreign exchange markets with a +iew to, a% 2nsure sufficient +olume as far as demand and supply for a particular currency is concerned and thus pa+ing the was for competiti+e prices for +arious currencies for co+ering merchant transactions. b% To de+elop lndian foreign exchange markets so that dealer de+elops dealing skills and sophistication. c% To keep Indian foreign exchange market getting integrated with the global foreign exchange market in due course of time 0s and when rupee becomes fully con+ertible on current as well as capital account The ris" management $rocess Banks should ha+e a comprehensi+e and accurate risk management process co+ering both trading and non.trading acti+ities. This procedure should enable the management to access exposure on a consolidated basis it should be easily understood by the dealers,
4H
4G
45
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'01s are generally used by: Banks to alter their exposure to interest rate mo+ements without interfering with their li7uidity profile. Borrower, lenders and in+estors to hedge against the future ad+erse interest rate mo+ements. $peculators by taking a +iew and seeking to profit from unpredictable interest rate mo+ements arbitrageurs using mispricing of '01s against other financial Instruments. FRAGo$eration Typically, a buyer of '0 wishes to minimi8e exposure to rising interest rates as a
borrower and a lender is seeking to minimi8e the exposure to falling interest rates. Aet us suppose that a corporate has to borrow #$$ 3G million, hence three months on a floating rate, say at AIB?' "Aondon Interbank ?ffered 'ate% rate but is comfortable at a rate, say maximum of 5 GN p a. $hould the interest rate rise during the inter+ening period i.e. from now till the actual date of borrowing, its calculations can go awry and may be the corporation suffers loss on account of rise in interest rates. The borrower can protect against such an e+entuality by buying an '0. %ho $ays and recei'es the sett&ement $roceeds If a corporation had agreed to buy an '0, then if the benchmark interest, say AIB?' rises and is at -N per annum on the fixing date i.e., rate rises abo+e the fixed rate of 1'0, the seller of the '0 will pay compensation amount and the buyer of the '0 will recei+e the compensation amount If the benchmark interest rate, say AIB?' is at 5N per annum on fixing date i.e., the rate remains lower than the fixed rate of '0. the buyer of the '0 will pay compensation amount and the seller of the '0 will recei+e the compensation amount.
4=
S%A4 In foreign exchange markets swap means simultaneous purchase and sell of the same amount of currency for two different +alue dates. In case of a swap as the bank buys and sales the same amount of currency against another currency, no exchange position is created. Therefore in a swap deal there in no exchange rate risk howe+er as +alue dates are different mismatch is created. Aet us consider the following transactions undertaken by a bank. Bank buys #$$ 3 million spot and simultaneously sells #$F I million one month forward 6e can appreciate from the abo+e illustrations that after undertaking a swap transaction, though no exchange position is created but as the inflows_ out flows do not match, the bank runs the risk of forward differentials "interest differentials% mo+ing against it. Banks enter in to forward purchase > sale contracts with customers bank and at that point of time co+er for the same +alue date many not be a+ailable. :owe+er if a bank, which has entered in to a forward contract, does not co+er its position, run exchange risks Therefore, it co+ers the transaction on spot basis i.e. if it bought #$$ 3 million two months forward, it will sell #$$ I million spot and s7uare its position Therefore to correct the mismatch of spot and two months forward it will do a swap by buying spot and selling two months forward. Theoretically a bank, which enters in to a forward contract with a customer to a+oid risk on account of exchange rate mo+ement, always co+ers itself. :owe+er the customer may not take gi+e deli+ery1 of foreign exchange on due date i.e. the customer may gi+e>take early deli+ery or cancel the contract or may extend the
44
I&&ustration or example if a bank entered in to a forward sale contract for say, 0pril DK and if the customer recei+ed the import documents on March D3st he may re7uest the bank to remit the foreign exchange on March D3st against the forward contract booked for 0pril DK, initially. Thus the bank may ha+e to under take the swap in the inter bank market by buying for March D3,3 and selling the same amount forward for 0pril DK. a% Banks undertake swap transaction for funding operations. $uppose a bank has to pay today against an AI9 opened by it and as at that point of time its Iostro account does not ha+e sufficient balance the bank to a+oid o+erdraft interest and in order to a+oid default, will undertake a swap in the inter bank market by buying cash and selling say spot or forward. Thus bank is in a position to fund its Iostro ac through swap without ha+ing exchange rate risk. b% Banks undertake swap transactions to take ad+antage of arbitrage opportunities buy con+erting one currency in to another temporarily without creating any exchange position. c% $ome banks undertake swap transactions for running a O swap book1. This is generally done by doing a forward > forward swap. d% oreign exchange swaps are used to manufacture a currency fund through one currency in another currency. Interest Rates G Ca$s. Co&&ars. F&oors
3KK
hedging their risk. Their instruments protect the corporates from interest rate +olatility. These are also used as by more enterprising fund managers to fund their medium ; term pro/ects with short ; term as they can hedge their exposure and thus gain confidence that e+en substantial +olatility in interest rates will ha+e no effect on profitability of their company. Interest Rate Ca$s: Interest rate is agreement between a bank and a corporate borrower with floating rate whereby the bank in return for a premium, undertakes to bear the extra cost on account of interest rate going up beyond the agreed rate during the agreed period. This instrument caps the interest payment of the borrower as and rise abo+e the cap will be borne by the bank selling cap to the corporate. If a corporate is in+esting in a pro/ect by borrowing at A3B?' Q3.GN and if the pro/ect is profitable at the maximum interest cost of say 4N per annum, in order to hedge against floating rate, the best thing the corporate could do is to buy a cap of 4N per annum. If the rate goes abo+e 4N , the corporate is protected as the seller of the cap will compensate the buyer for the :difference. In case the interest rate remains lower, the corporate can en/oy this benefit. Interest Rate F&oor: Interest 'ate loor is an agreement under which a bank and a corporate lender on floating basis agree that the bank for a premium will set floor on the interest income earned by the corporate lender. $uppose the corporate is funding its 4N assets by borrowing on f3oatin basis. The assets become loss.making proposition if the floating interest goes beyond 4N. The corporate by paying a lump sum premium can buy a floor, which will ensure a return of 4N on the assets. Incase the interest rise abo+e, 4N. The corporate will en/oy the extra interest Interest Rate Co&&ars:
3K3
If a corporate takes a +iew that the interest rates will remain in a range, it can combine cap and floor to achie+e the ob/ecti+e. If we consider a situation where corporate had a bought a cap on interest rate at 4N, and if it is of the +iew that the interest rate will not fall below, say -N Therefore it buys a )collar* of between -N and 4N on interest payment that it has to pay The corporate loose the benefit if interest falls below -o but for foregoing this, it pays less premium It has protected its upside risk at a +ery low cost.
Financia& Futures
0 future contract is a firm obligation to gi+e or to take deli+ery of the commodity of specific 7uantity and 7uality at a specific date at an agreed price. The seller is called Othe short1 and the buyer is called Othe long1. urther it re7uires that all the futures contracts be bought and sold on Odesignated contract markets1. There are basically @ types of future in the market and these are differentiated on the basis of underlying. If the underlying is a commodity futures and if the underlying is a Ofinancial instrument1 these are known as financial futures. inancial futures are a+ailable in the market with the following underlying: Interest 'ates 9urrency 2xchange 'ates $hare !rice Indices @edging through Financia& Futures:
3K@
Currency Futures
0 currency futures contract is an agreement to buy or sell at Ofutures exchange1 a standard 7uantity of a foreign exchange at a future date at the price agreed to between the parties to the contract. 0lthough the contracts are traded between the @ parties, howe+er, for clearing purposes Oclearing house1 of Ofutures exchange1 is the counterparty to a large extent. ?nce a futures contract has been entered in to the short "seller% has to gi+e deli+ery to the long "buyer% of the underlying. :owe+er physical deli+ery in the futures contract is
3KD
CURRENT AFFAIRS
Uniting Asia Through a Common Currency
6ith the introduction of the 2uro on Ban1 3st 3444, the world is slowly shifting towards a three currency system ; &ollar, Cen and the 2uro. This will gi+e the concerned countries tremendous competiti+e ad+antage o+er their 0sian counterparts. To counter this possible threat there has been talk in the 0sian financial circles about the feasibility of introducing an 0sian common currency based on the 2uro. :owe+er we need to be clear as to why countries form unions on the basis of a single currency. 6ell, currency unions are generally formed as a part of a more comprehensi+e strategy to integrate the economies that wish to be a part of the union. 0 common currency is usually followed by synergising the +arious legal frameworks, framing free trade agreements and migration laws. 2ntering a currency union, thus, is a foreign policy decision of immense importance and needs a careful and detailed analysis of the pros and cons. 0t this point I would like to differentiate between two terms that can be confused . L 9urrency +nion, and L-ollarisationL. 6hile the former implies a formation of a new
3KH
0 common currency will lead to reduction in the transaction costs for the traders. $ince business within 0sia will be conducted in the common currency, it will eliminate the need for currency con+ersion.
'eduction in the Iominal 2xchange 'ate #ncertainty for the traders of the member countries is likely. This reduced uncertainty should ideally gi+e a fillip to the intra.union trade.
0cting as a union would pro+ide the countries with a bargaining power +is a +is the rest of the world, which indi+idual nations cannot achie+e.
0 +ery important ad+antage that the single currency would ha+e o+er the dollar and euro is the fact that 0sia has control o+er the ma/or oil reser+es "$audi 0rabia, (uwait, Iran etc.%. This will, in turn , ha+e the following implications: 0sia will be able to pressuri8e the world into trading in their common currency. $ignificant impro+ement in the B?! of the member states will be possible leading to reduced dependence on the +arious sources of external aid.
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It will lead to greater market transparency by making prices of the products across nations "within the union% easily comparable.
%hat can 2e the F&i$side o# such a system( The first thing that comes to the mind when we talk about the disad+antages of a single currency is: L 6ho will ha+e control o+er the +arious countries1 monetary policySL 0 nation must be prepared to lose some degree of control o+er its monetary policy and be satisfied with a reduced ability to offset demand shocks and to influence their own inflation rates. 'ecent international experience suggests that this loss can pro+e to be of great significance "the fact that 0rgentina went through se+ere recession was primarily because of its tie up of the #$ F%. Transition to the common currency ; the way I see it: 3. The transition should broadly be on the lines of euro. @. The single currency should be introduced in a phased manner gi+ing ample opportunities to the member states to ad/ust and adapt to the changed en+ironment. D. 0t the time of introduction, the exchange rate between the common and indi+idual currencies should be irre+ocably fixed. H. The countries be allowed to use both the currencies during the transition period. G. I now mo+e o+er to the +arious issues that seem to be important and need due attention if the transition from multiple to single currency is to be smooth and successful: a. $trategic: there are compelling reasons as to why formation of an 0sian trade block "0sian monetary union% will be a strategic mo+e with great conse7uences. The union will comprise of two of the fastest growing economies on the planet "India and china%. It will also offer a single largest market for a range of commodities from computers to cars. This will enhance the bargaining power of the block gi+en the saturating 0merican and 2uropean markets.
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b. 2conomic: introduction of the single currency impacts more than /ust currency of payment , it has se+eral economic effects as well: irms that practice price discrimination "charging different prices in different geographical markets and thereby reaping hea+y profits% will lose this luxury after the system comes into force. 9ompanies, which will be able to charge their customers in the currency units of their choice, will become more popular than their competitors. The 0sian monetary union will be able to impose tariffs on the goods from non.0sian countries. This would make their products more expensi+e and would aid in increasing the sales of 0sian countries to the fellow member states. c. Technical: this basically deals with need to make +arious financial information systems of the countries compatible with the common currencies. 0s a result a larger percentage of the accounts of the concerned countries of the world will need updation. or a country like India it may pro+e to be a blessing in disguise because of its cheap and skilful software professional pool also it will ha+e an opportunity to de+elop the financial system at a much lower cost.
d. !olitical: to me this is easily the most +ital ingredient in the recipe of a successful 0sian currency. ,i+en the heterogeneity among the 0sian countries ;the form of go+ernment, language, culture, +alues, religion, etc, a financially united 0sia will only be a dream if these differences are not harmoni8ed and a collecti+e effort made. More o+er relations between the
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rea!-E%en Point The price of a financial instrument at which the option buyer recovers the premium. retton &oods
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3uote n indicative price. The price quoted for information purposes onlyO not to deal. Range The difference between the highest and lowest price recorded during a given trading session.
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